March 6, 2018. By Mark Barry:
A target-date fund (also known as a life cycle fund) is a mutual fund in the hybrid category that automatically resets the asset mix of stocks, bonds and other investments according to a specific time frame. Typically, this time frame is years until retirement. For example, a 2030 Fund would be intended for investors who expect to retire in the year 2030. The underlying holdings are typically comprised of a number of different mutual funds investing across a variety of different asset classes and strategies, although some do hold individual stocks and bonds. These funds are popular investment choices in 401k plans, and oftentimes are the default option for new participants.
A key benefit of target date funds is their simplicity; instead of having to build an appropriate portfolio by selecting multiple investments, a participant can select one fund that is appropriate for their age and risk tolerance. The funds are constructed to be adequately diversified among the various asset classes, and the fund manager periodically rebalances the portfolio, taking these decisions out of the hands of the investor. However, it is important to note that these funds are not guaranteed – if stock and bond market performance is poor, these funds can and do lose money.
The investment manager of a target date fund uses a glidepath to adjust the mix of investments that make up the target date fund, an example of which can be seen below:
(Glide path example sourced from Fidelity Freedom Fund marketing materials.)
The fund’s glidepath sets the broad asset allocation of the fund, and this asset mix is the primary driver of returns. For younger investors, their asset allocation will tilt heavily towards equities, as they have many years until retirement and thus a higher risk tolerance. As investors move closer to retirement, the target date fund will reduce the percentage allocated towards riskier assets like equities and increase the allocation to less risky investments such as fixed income and money market instruments. In sum, the fund becomes more conservative over time.
While Target Date Funds can be simple and efficient investments for 401k plan participants to save for retirement, investors still need to give careful consideration to the target date funds offered in their plan. Like the majority of investment products, there are good ones and bad ones. A few questions investors should consider are:
- How the fund is managed – is the fund passively indexed or actively managed? Does the fund invest in individual stocks and bonds, or is it a fund of funds structure?
- Fees – what is the total all in cost of the fund? Is it significantly more expensive than the other investment options?
- How does the glide path for this specific fund work – is it more/less aggressive than other options in the category? After you reach retirement age is the allocation static or does it continue to be adjusted?
- Will you be combining it with other investments – using a target date fund as the sole investment in an investor’s 401k plan is usually a good option, but if you plan to combine it with other investments, you should know your overall allocation and how the investments fit together.
- Is the fund appropriate for your individual risk tolerance – it may be the case that you are a very conservative investor, which would make it unlikely that the target date fund recommended for your age would be appropriate
If at any time you have questions regarding target date funds as they relate to your retirement or investment strategy, do not hesitate to reach out and we will be happy to help you navigate these vehicles.